What do you know about GAAP? Unless you are knowledgeable about accounting, probably very little. GAAP is short for Generally Accepted Accounting Principles. Sounds like boring stuff you don’t need to know about, right? Well, that might be true for the most part, but it is important that you know enough about what GAAP is so that you don’t get faked out by people or groups that would rather you not have the truth about certain charities.
Sometimes critics of CharityWatch or charities that are trying to defend against poor ratings given to them by CharityWatch comment in the media that “CharityWatch’s ratings do not follow GAAP.” This seems to be a particularly popular critique in the right-wing media this election season with regards to the Bill, Hillary & Chelsea Clinton Foundation and the "A" rating it receives from CharityWatch. After a simple explanation of what GAAP actually is, however, we think you will agree that the notion that CharityWatch’s ratings should “follow GAAP” is nonsensical. Moreover, as a donor, you will appreciate how the adjustments that CharityWatch makes to a charity’s financial reporting (GAAP based or otherwise) provide you with a more complete picture of how efficiently a charity spends your cash donations on bona fide charitable programs.
Generally Accepted Accounting Principles (GAAP) are the set of accounting standards that were developed and established by two accounting standard-setting Boards to determine how financial statements are prepared and presented. GAAP can be applied to the financial statement reporting that covers information such as an organization’s statement of financial position (or balance sheet) and results of operations (or statement of revenues, expenses and changes in net position), as well as the associated financial statement disclosures. The key here is that GAAP covers how financial statements are prepared, not how financial statement information is evaluated.
The ratings CharityWatch produces for donors are not financial statements – they are an analysis and evaluation of the financial information that is reported by charities on audited financial statements and IRS tax forms. This is the reason why it is makes no sense at all to try to claim that CharityWatch’s ratings should “follow GAAP.” It would be akin to trying to claim that a stock analyst or investment fund manager should “follow GAAP” when analyzing, evaluating and publishing buy/sell reports on for-profit companies for stock market investors. For example, a company’s GAAP audited financial statements may make it appear very profitable, but if a material portion of that profitability was due to an extraordinary source of income such as a windfall from a successful lawsuit, in evaluating that company, a financial analyst likely would adjust out the extraordinary income item and use that resulting lower profit margin as an indicator of the company’s profitability going forward. Simply put, GAAP does not apply to financial efficiency evaluation methods, and CharityWatch’s ratings are just that – our evaluation of a charity’s financial efficiency.
Where GAAP does come into play for CharityWatch is that we scrutinize the audited financial statements of the charities that we rate, and audited financial statements must be prepared in accordance with GAAP. (The same is not true for the financial reporting in a charity’s IRS Form 990 tax filing, which uses the IRS’s own set of reporting instructions and guidelines.) The truth is that GAAP offers a wide latitude of choices in how some financial activities are reported on a charity’s financial statements. Moreover, GAAP financial reporting standards do not measure (or claim to measure) how efficiently an organization is raising and spending donated dollars. For example, a charity can spend as little as 1% of its budget on programs and still be in compliance with GAAP (and IRS) requirements. This is why CharityWatch’s services are needed – because we evaluate the information that is reported on the GAAP financial statements of charities and make it more meaningful from a donor-perspective.
Part of the way in which CharityWatch turns a charity’s GAAP financial reporting into more meaningful financial efficiency information for donors is by making certain adjustments that allow for greater consistency and comparability among the over 600 charities that we rate. Two standard adjustments that we make in conducting our charity ratings relate to the financial reporting of solicitation campaign “joint costs” and contributions of “gifts-in-kind.” For some charities, our evaluation of how joint costs and gifts-in-kind should be viewed by donors can result in dramatically different program services and fundraising spending ratios compared to those claimed by the charities themselves. Since these differences are unfavorable to the charities, they sometimes become defensive and try to refute our ratings by claiming that “CharityWatch doesn’t follow GAAP,” which as we covered above is a nonsensical argument. In reality, CharityWatch publishes its ratings (which are not subject to GAAP) with the mission of providing donors with the information they need to make more informed giving decisions, and we believe that our evaluation methods better reflect the goals of many donors who want their donated dollars to be spent on bona fide charitable programs.
For those that are interested, more details behind why CharityWatch’s ratings include adjustments to a charity’s financial reporting of solicitation joint costs and gifts-in-kind are provided below.
Joint Costs – One of the most contentious adjustments CharityWatch makes to a charity’s financial reporting relates to “joint costs” from a combined educational campaign and fundraising solicitation. GAAP allows charities to report as charitable program services the expenses related to direct mail and telemarketing solicitations with educational messages that also include an “action step” or “call to action.” The accounting rules for joint costs require that certain criteria be met before a charity can allocate a portion of such solicitation costs to its program expenses, but the joint costs criteria are subjective in nature and leave room for biased interpretation by charities. Moreover, the accounting rules do not mandate a specific method for allocating the solicitation costs between fundraising and program expenses, which creates variation in how joint costs are applied by different charities.
Some charities take full advantage of the subjectivity allowed by joint costs accounting rules to allocate a significant portion of their direct mail and telemarketing solicitation costs to program services, thereby giving the false impression that charitable program spending is much higher than it truly is, at least from the perspective of most donors. Since CharityWatch believes that most donors do not consider joint solicitation/educational activities to be equivalent to the substantive programmatic activities (e.g., assisting injured veterans; conserving the environment; feeding the hungry; funding medical research; protecting animals) they are intending to support with their charitable donations, our ratings typically reflect an adjustment that reallocates to fundraising expenses the solicitation joint costs reported as program expenses. This joint costs adjustment provides donors with a more complete and comparable picture of a how efficiently a charity is spending donated dollars on bona fide programs. (Note: CharityWatch makes an exception for the program joint costs reported by social welfare advocacy groups with 501(c)(4) tax exempt status, allowing up to 30% of such costs to be included in program expenses.)
Gifts-in-Kind – Another adjustment CharityWatch makes to a charity’s financial reporting relates to non-cash donations, also known as “gifts-in-kind” (GIK). GAAP allows charities to report as part of their revenue and expenses a monetary value for the receipt and distribution of unidentified GIK. GIK may be in the form of goods (e.g., clothing, equipment, food, medicine, etc.) or services (e.g., advertising, legal services, management consulting, professional medical care, etc.). For some charities, GIK valuations are so high relative to the actual dollars a charity receives and spends that they can dramatically distort the charity’s financial efficiency ratios, giving the illusion of much higher program spending and lower fundraising costs than is the reality on a cash basis.
Since CharityWatch publishes its ratings to help donors understand how efficiently their cash donations are being raised and spent by charities, we exclude from our ratios the value of gifts-in-kind reported by charities. Another reason we exclude GIK items is that GIK reporting and valuation methods can be subjective and may vary significantly from one charity to the next. CharityWatch has detected numerous cases of charities grossly inflating the value of its GIK (see The Alice in Wonderland World of Charity Valuation). Also, the reporting disclosures related to GIK are especially inconsistent on GAAP audited financial statements. Therefore, by adjusting out the GIK valuations reported on a charity’s financial statements, the program services and fundraising cost ratios in CharityWatch’s ratings are calculated on an apples to apples basis, regardless of whether or not a charity has manipulated the value of its GIK. This GIK adjustment provides donors with more consistent and comparable information to use in their giving decisions.
After reading more about GAAP financial reporting, joint costs, and gifts-in-kind, we hope that you better understand some of the ways in which CharityWatch evaluates the financial statements of charities and why we believe our charity ratings are helpful from a donor’s perspective.